Credit and debt are central to a modern economy. For better or worse, when borrowing is robust, other financial indicators often follow suit. However, debt that is unmanageable can seriously disrupt–if not destroy–household solvency. For this reason, as well as for their own protection, financial institutions carefully underwrite loan applications, determining whether or not a borrower can comfortably absorb monthly payments. Each bank measures the debt acquired against the revenue received. This figure is the debt to income ratio (DTI).
How Is DTI Calculated?
In order to ascertain what is a good debt to income ratio, a consumer best learn what goes into this all-important number. At its essence, the DTI is the quotient of the monthly debt payment total and the gross monthly income. That is, debt payments are divided by the aggregate income. Debt may include credit card remittances, mortgage payments, car loan installments and student loan reimbursement. Alimony and child support likewise fall in this category. Not counted among debts are utility bills, telephone and internet services, cable TV and monthly grocery charges (unless paid by credit card, of course).
Few exceptions, on the other hand, apply to income. Interest earned on certificates of deposit, individual retirement accounts, 401ks and other savings instruments do not qualify as income for DTI purposes. It does, nevertheless, count as assets, and can only enhance a loan application. Still, underwriters look for salaries, wages, tips, investment dividend pay-outs and business revenue when weighing gross monthly income. In brief, any earnings or payments that the borrower receives on a consistent schedule–i.e. effective income–goes toward DTI.
Different Loans, Different Ratios
The good news for those with modest incomes is that there is no sole criteria for what is a good debt to income ratio. The type of credit in question affects this number, as does the nature of the lender. For example, the Federal National Mortgage Association (aka Fannie Mae), one of the largest government-chartered mortgage investors in the United States, holds to 50 percent as a general rule, but 36 percent when credit issues arise. Therefore, lenders that sell to Fannie Mae must maintain the same (or stricter) standards.
By contrast, a home loan that is guaranteed by a government agency like the Federal Housing Administration (FHA) or the Department of Veterans Affairs can be more flexible with DTI because that department is on the hook if the borrower defaults.
Credit card issuers, by contrast, are not as focused on DTI as mortgage and auto finance providers. Though income and credit history matter very much to them, they are more likely to leave the matter of debt capacity up to an otherwise well-qualified borrower.
In the end, banks and finance companies must make the call on where acceptable DTIs fall. Smaller, community-based lenders might be more liberal (>50 percent) if they service their own loans and do not sell them on the secondary market. This is especially true if the applicant has deposits with the bank and they know him or her.
What about “Sub-Prime” Loans?
A legitimate question relates to what is a good debt to income ratio when applying for a loan with a sub-prime institution. Should the DTI requirements be somewhat, well, looser? Since the 2008 banking crisis, the term “sub-prime” fell out of favor, since a good deal of the problems arose from so many investing in defaulting mortgages. Yet the less-than-perfect credit borrowers are still out there and there are banks still willing to help them. Today, they are “non-prime” lenders and they are still famous for making allowances.
Up to a point, that is. One non-prime bank executive stresses that when lenders take risks with bad credit borrowers, they must compensate for the risk in other components: adequate savings and assets; steady employment and job history; and reasonable DTI. While it may not be fruitless to check such lenders out, mortgage-seekers should not assume that nonprime DTIs will be significantly higher than those of conventional lenders. Then again, the millennial generation might just push these ratios higher.
The Demographics of Debt
What is a good debt to income ratio? It might depend on whom you ask. Whereas previous generations were by necessity more thrifty, recent ones produced a culture for which borrowing is a simple fact of life. Millenials, specifically, carry heavier debt burdens than do baby-boomers or Gen-Xers. Most of these obligations are in the form of student debt. Forbes magazine reports, for instance, that the average twenty-something college graduate is paying $350 per month in school loan reimbursement.
When larger financial encumbrances become more commonplace, pressure will rest on lenders to raise their maximum DTIs for the sake of profit and even survival. This, though, can be an ominous sign since there is only so much debt that income can carry. Should DTI requirements loosen further, the economies of the world may suffer another credit crisis, perhaps a worse one.
How to Improve DTI
Once a prospective borrower can determine what is a good debt to income ratio, he or she can then strive to fit within an approximate range. This is a slower and more difficult task on the income side. Getting a raise, or a better paying job or even a second job can raise the divisor side of the ratio over time. The dividend side–the debts–will shrink when the obligations are paid down…without incurring any new ones. The two are not mutually exclusive: more income can lead to faster debt reduction.
Underwriters do what they do to protect their employers’ bottom lines. DTIs, nonetheless, also keep borrowers from entering into reckless contracts with lenders. As noted above, there are other monthly expenses besides consumer debt. Emergencies happen and surprises ensue, draining more of the precious household income. Maintaining a decent cushion benefits borrowers and lenders alike. That is why all parties should take an interest in what is a good debt to income ratio.